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The Stealthy Public Pension Time Bomb

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As state and local government budgets have come under increasing stress, greater public attention has come to focus on government employees' compensation. This greater scrutiny has led to public anger over public employees' generous compensation (along with their iron-clad job security). Naturally, this has put public employee unions and their allies on the defensive. Some have responded with publications that essentially retort, "It ain't so!" In The American, Andrew Biggs of the American Enterprise Institute, responds to that defense. As he notes, a significant such study, by the Center on Wage and Employment Dynamics (CWED) at the University of California-Berkeley, makes an important miscalculation:

The basic problem with CWED’s treatment of benefits is that it assumes data showing what employers currently pay toward benefits is equal to what employees will actually receive. In the short-term, this assumption is fine, since many employee benefits are consumed today. But in the public sector, a large share of compensation is deferred to retirement in the form of pension benefits and retiree health benefits. The CWED study significantly underestimates the value of deferred benefits.

As many people are aware, public sector defined-benefit pension plans are significantly underfunded. Using private sector accounting standards, which is necessary to make apples-to-apples comparisons, the typical public pension is less than 50 percent funded. When pensions are underfunded, compensation from pensions is underestimated.

Thus, although the CWED study argues that California’s public sector employees receive pension benefits equal to 8.2 percent of their total compensation, that’s not exactly true. Their data actually shows that California public employers are paying 8.2 percent of employee compensation toward pensions, but that is only around half what employers should be paying. And since public pension benefits are guaranteed, that extra amount will be paid sooner or later. A good guess of true public pension compensation is to divide the reported pension contribution of 8.2 percent by the 50 percent funding level of California pensions, producing a value for promised pension benefits of 16 percent of compensation. This increases the 2 percent pay advantage that the CWED study already acknowledges to a public sector pay premium of around 10 percent.

So, in addition to threatening state and local government finances -- and thus by extension taxpayers -- public employee pension underfunding also partly obscures the real cost of public employee compensation. For government employee unions and the elected officials they support, this politically convenient, since they simply pass on the cost to future taxpayers, while mitigating current taxpayers' wrath. For some insight into how they do this, it's worth reading the study by Biggs and Eileen Norcross of the Mercatus Center (who's also a former CEI Warren Brookes Journalism Fellow), on the public pension underfunding crisis, published by Mercatus. In a word, public pension managers have been overestimating investment returns for years. They focus on New Jersey as a case study.

The state reports that its pension systems are underfunded by $44.7 billion, when liabilities are discounted at the 8.25 percent annual return that New Jersey predicts it can achieve on funds' investment portfolios.

However, when plan liabilities are calculated in a manner consistent with private sector accounting requirements, methods that economists almost universally agree are more appropriate, New Jersey's unfunded benefit obligation rises to $173.9 billion. This amount is equivalent to 44 percent of the state's current GDP and 328 percent of its current explicit government debt.

Such unrealistic investment return expectations lead to further underfunding. One necessary first step to alleviate this situation, Biggs and Norcross note, is honest accounting.

In addition to understating funding requirements, using a high discount rate to value public pension liabilities encourages plan managers to invest in higher risk portfolios in order to target the expected rate of return, producing bad incentives in the management of pension assets. Instead, financial theory suggests pensions should be discounted according to the lower risk (and lower return) Treasury bond rating of 3.5%.

Government employee unions are a formidable political force. However, the public pension underfunding problem is so large now that public support for reforms to get states out of the red finally has a good chance of carrying the day, as it did in Utah. As Utah State Senator Dan Liljenquist, who helped design and enact a major pension reform in his state noted recently at a Mercatus event (where Biggs and Norcross also presented): “This is not a conservative-versus-liberal issue, this is a reality issue.”